Lloyds Banking Group plc should be worth 113p

It has been nearly a decade since the Lloyds (LSE: LLOY) taxpayer bailout, although it seems investors are still finding it hard to trust the company.
Indeed, despite the progress the bank has made since 2009, the shares still trade at a discount to international peers. This might be easy to explain if Lloyds had the same problems as peers RBS and Barclays, but after seven years of aggressive restructuring, the bank is now one of the most productive financial institutions in the euro area. What?s more, Lloyds has an enviable capital position and is one of the most cash generative stocks…

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It has been nearly a decade since the Lloyds(LSE: LLOY) taxpayer bailout, although it seems investors are still finding it hard to trust the company.

Indeed, despite the progress the bank has made since 2009, the shares still trade at a discount to international peers. This might be easy to explain if Lloyds had the same problems as peers RBS and Barclays, but after seven years of aggressive restructuring, the bank is now one of the most productive financial institutions in the euro area. What’s more, Lloyds has an enviable capital position and is one of the most cash generative stocks listed in London today.

Specifically, at the end of 2016, the bank reported a post-dividend pro forma tier 1 capital ratio of 13.8%. Throughout the year, the bank generated 1.9% of this capital buffer excluding dividends paid to shareholders. Management has previously indicated that anything above the 12% capital ratio level is considered to be excess capital. In other words, as most of the bank’s European peers struggle to raise capital from investors, Lloyds has too much capital and is generating nearly 2% in excess capital every year.

Improving profitability

Lloyds continues to seek ways to improve efficiency and is targeting a sustainable return on equity of 13% to 15% per annum in 2019. Underlying return on equity was 13.2% for 2016. For some comparison to show just how impressive this performance is, the average return on equity of all US banks during the fourth quarter of 2016 was around 9% for the year. US banks are more productive than their European peers as US economic growth has been on the up and up for several years and interest rates are higher than the negative deposit rate currently in place at the ECB.

However, while Lloyds is more efficient than its US peers, the bank’s valuation does not reflect that. The shares currently trade at a price-to-tangible book ratio of 1.2 times compared to the US bank average of two. If the shares were to trade up to this valuation, they could be worth as much as 113p.

What are the chances of the shares reaching this level? It currently looks as if Lloyds’ shares are suffering from a Brexit hangover, as well as scepticism surrounding the general European banking industry. While it may take some time for this scepticism to dissipate, Lloyds remains an attractive investment. Excess capital generation will likely lead to dividend growth (as well as special dividends), giving investors an attractive income stream while waiting for sector confidence to return. For 2017 the shares are expected to support a dividend yield of 5.5%.

Foolish summary

Overall, even though Lloyds is now one of the most productive and efficient banks in Europe, the market still seems to dislike the company.

Nonetheless, even though investors may not be willing to award the bank a high valuation, it remains an attractive income play with plenty of capital growth potential as the market wakes up to the growth story.

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Lloyds is a top income stock, which makes it the perfect buy for any investor's portfolio. Using dividends to help grow your wealth is a key part of investing, but some investors fail to follow this easy strategy.

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Barclays and Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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